Cathay Pacific’s valuation sinks near trough; 2019 profit jump could present buying opportunity

Cathay Pacific company logo

Cathay Pacific Airways Ltd (293:HK)

Price Target: HK$14.00 | Rating: Buy

9 August 2018, Hong Kong – Cathay Pacific fell into the red again in 1H18, reporting a net loss of HK$263 million and net loss margin of 0.5%, after earning a net profit of HK$792 million in 2H17. This beat our more conservative loss estimate but disappointed the market which was expecting the carrier to be profitable. Cathay’s 1H18 financial results were boosted by favourable currency movements and a gain from the disposal of EU CO2 emissions credits. Excluding these, the Airlines segment incurred a larger adjusted loss of HK$1.1 billion before tax. (It would have helped investors if Cathay restated all its 2017 financial and operating data to facilitate a like-for-like comparison of the year-on-year trends following the adoption of new accounting policies, in our view.)

Going forward, we expect Cathay Pacific’s earnings outlook to remain challenging in 2H18 but the airline’s profitability will improve markedly in 2019 when more of its Transformation initiatives bear fruit. We maintain our current 2018 forecast, expecting Cathay to report a small net profit of HK$202 million but see downside risk to consensus' higher estimates. We expect to see stronger profitability improvement in 2019, delivering a net profit of HK$2.5 billion.

Cathay Pacific’s valuations have fallen back to 0.7x Price/Book valuation currently, close to its historical trough valuation of 0.6x P/B during the Global Financial Crisis in 2008 and 911 Attacks back in 2001; its improving profitability in 2019 could present a buying opportunity for longer term investors as much of the negative drivers have already been priced in. We have a Buy rating on the stock and price target of HK$14.0.

Here are our views on Cathay Pacific’s operating outlook in 2H18 and beyond:

Chart: Cathay Pacific Price/Book Valuation (2001 to 2018)

Cathay Pacific Price/Book Valuation (2001 to 2018)

#1 Benign industry supply growth environment in Hong Kong could aid Cathay Pacific’s pricing power in 2H18, as long as travel demand stays firm

Cathay Pacific’s passenger yields improved significantly by 7.6% y/y (or 6.6% excluding the impact of adopting IFRS 15 accounting standard) in 1H18, which was lacking in Singapore Airlines’ financial results. See our previous reports for the details:

Cathay Pacific refocusing on yield instead of market share but Hong Kong Airlines threat looms

Fuel hedging gain saves SIA from losing all its profits in 1QFY18/19

This was mainly driven by stronger yields in the premium class segment, improved overall passenger traffic mix, more favourable forex and higher fuel surcharges. Cathay’s investments in upgrading their product and improving its revenue management also appear to be paying off.

Given Hong Kong International Airport’s rising capacity constraints during peak timeslots until the new Three Runway System is completed, the overall airline industry capacity growth to/from Hong Kong is expected to be low at 4% in 2H18, based on our estimates. Therefore, if travel demand stays firm, the benign demand and supply environment can help Cathay maintain or even gain pricing power in 2H18.

Meanwhile, Cathay Pacific is gaining connecting traffic market share from the Gulf carriers on Transpacific routes. We believe Qatar Airways’ 9.61% equity investment in Cathay is likely to ease its competitive threat to Cathay as well.

The key competitive pressure will come from Hong Kong Airlines which is increasing its capacity by 30% y/y as it ramps up its long-haul route expansion. Moreover, there has been an increased number of airlines flying to Hong Kong in the past year, from 83 carriers in 2017 to 89 carriers currently.

#2 Currency movements will have less favourable impact in 2H18

The strengthening of Cathay’s key foreign revenue currencies, including the British Pound, Euro, Australian Dollar, Renminbi, helped to boost Cathay’s passenger yields and share of profits from Air China in 1H18. However, given the recent rebound in the US dollar, we expect the currency effect to be less favourable in 2H18.

#3 Cargo demand growth to moderate with escalating trade tensions

Cathay’s cargo yields surged 16.3% y/y, lifting Cathay’s cargo revenue by 23.4% y/y in 1H18, contributing 24% of Cathay’s total revenue. As the world’s second largest international cargo airline, Cathay is benefitting from strong cargo shipments on long-haul routes to North America and Europe as well as rising inbound cargo traffic to Asia, improving the trade imbalance. The capability to carry high value-added cargo has also helped to enhance Cathay’s yields.

Although the global air cargo demand has not been hurt by the trade tariffs so far, this could change as trade tensions escalate, in our view. The recent proposed trade tariffs could impact semiconductors and automotive parts which are normally transported by air.

#4 Profit contribution from 18.13%-owned Air China to drop in 2H18

Cathay’s 1H18 results were boosted by higher profits from 18.13%-owned Air China. However, we expect Air China to contribute lower profits to Cathay Pacific in 2H18 due to the higher fuel costs and weaker Renminbi. Therefore, Cathay will need to deliver stronger Airline results to make up for the reduced profits from associates in 2H18.

#5 Aircraft fleet upgrade will improve fuel efficiency further

Cathay’s fuel consumption per RTK fell 2.5% y/y in 1H18. We expect Cathay’s fuel efficiency to improve further as it retires its older planes and takes delivery of more Airbus A350-900 and A350-1000 aircraft, mitigating the impact of higher fuel prices. Cathay’s aircraft fleet simplification of its sub-fleets will also improve its operating efficiency.

#6 Moving from fuel hedging losses in 2H18 to fuel hedging gains from 2019 as expensive legacy hedges finally expire after 5 years

Cathay’s fuel hedging strategy has proven to be counter-productive in the past 4.5 years and the key culprit behind its financial losses. Unlike its major competitors (e.g. SIA, ANA, JAL, European airlines) whose hedging gains help to mitigate the impact of higher oil prices, we expect Cathay to continue to incur fuel hedging losses due to its expensive legacy contracts in 2H18. Cathay has hedged 45% of its 2H18 fuel needs at US$80.5/bbl, still US$5/bbl out of money. Cathay has incurred massive HK$25 billion fuel hedging losses since 2014! See our previous reports for more details:

A Tale of Two Airlines’ Fuel Hedging Strategy – SIA to beat Cathay

We expect Cathay to finally start realizing fuel hedging gains from 2019. Cathay has hedged 29% of its 2019 fuel requirements at US$65/bbl Brent crude oil price which is US$10/bbl in the money. Cathay has also increased its fuel hedging requirements for 2020 – it has so far hedged 8% of its 2020 fuel requirements at US$66.5/bbl. This, plus its more fuel-efficient planes, will significantly reduce Cathay’s unit fuel cost per ATK from 2019 onwards.

Chart: Cathay Pacific fuel hedging loss (2014 to 1H18)

Cathay Pacific fuel hedging loss (2014 to 1H18)

#7 Needs to drive down non-fuel unit costs to be competitive

Cathay’s underlying unit cost per ATK excluding fuel and exceptional items and after adjusting for the effect of foreign currency movements and adoption of HKFRS 15 rose 3.3% y/y in 1H18, which was worse than our expectations.

Therefore, Cathay still has to work on improving its non-fuel cost efficiency, in order to meet its ambitious Transformation Programme targets. We expect further restructuring of its operations, overseas stations and staff headcount. More significant staff cost savings can be achieved if Cathay manages to trim its pilot-related costs but this is also one of its most difficult tasks at hand given the strong union and risk of flight disruptions. Tackling rising maintenance costs will be a challenge for Cathay as well.

#8 Balance sheet strengthened; expect more dividends in 2H18 and 2019

Cathay generated positive free cash flows of HK$4 billion in 1H18 based on our estimates. This has helped to reduce its net debt-equity from 0.97x to 0.85x at the end of June 2018, the first decline in gearing in the past 7 years. Cathay declared an interim dividend of HK$0.10 per share (ex-date 5th September 2018) and we expect its full year DPS to be HK$0.20, implying a dividend yield of 1.7%. It would have been more pragmatic to conserve the cash to pay for its higher aircraft capex in 2H18 in our view.

#9 Valuations have fallen close to record low levels, discounting much of the negative drivers

Cathay’s book value per share has increased 6.5% y/y to HK$16.5, implying that Cathay is trading at only 0.7x Price/Book valuation currently, close to its historical trough valuation of 0.6x P/B during the Global Financial Crisis in 2008 and 911 Attacks in 2001. Cathay Pacific’s improving profitability in 2019 could present a buying opportunity for longer term investors as much of the negative drivers have already been priced in.

 

Note: Stocks with upside of more than 10% based on our fair value are assigned an Outperform rating. Stocks with downside of more than 10% based on our fair value are assigned an Underperform rating. Stocks with upside or downside of less than 10% based on our fair value are assigned an In-line rating. These are Crucial Perspective’s proprietary rating classifications and by no means serve as investment recommendations.

Independent Research Declaration: Crucial Perspective does not own any position in the equities featured in this report nor have we received any compensation for writing this report. 

 

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